When investors decide to put money into a company, chances are they’ve looked at
its financial statements, which contain audited reports of the organization’s accounts,
giving them the confidence to part with their money.
For a majority of large, publicly traded companies, these audits are conducted by one of the Big
Four accounting firms: KPMG, PWC, EY and Deloitte.
But their dominance is under threat from regulators.
Following the collapse of some high-profile companies, scrutiny is on the conflict of
interest between the accounting industry’s audit and non-audit services.
It’s led to calls from the public, politicians and regulators for the break-up of the Big
Four and a shakeup of the accounting industry.
In 2001, energy company Enron collapsed amid accusations of accounting fraud, which was
at the time, the largest corporate bankruptcy in U.S. history.
The demise of a publicly listed company that was worth over $60 billion left many asking
how the firm’s auditors, Arthur Andersen, could have signed off on accounting books
that overstated the energy giant’s profitability.
Arthur Andersen ended up being another casualty of the scandal, convicted of obstructing justice
and losing the right to file accounts.
Less than a year after its conviction, the fate of America’s oldest accounting firm
was effectively sealed, even though the Supreme Court later overturned the ruling.
Andersen’s firms around the world were then sold off to members of what became the Big Four.
But before the emergence of the Big Four, the market for audit services was dominated
by eight companies that were created through alliances across the Atlantic and beyond.
Along with Arthur Andersen, the eight included Arthur Young, Coopers & Lybrand, Deloitte
Haskins & Sells, Ernst & Whinney, Peat Marwick Mitchell, Price Waterhouse, and Touche Ross.
The Big Eight, as they were known, grew rapidly amid a wider consolidation within the industry,
including smaller firms like KMG which merged with Peat Marwick to eventually become KPMG.
Marketed as modern, global business networks, competition between the eight intensified
as they expanded internationally.
By 1989, the Big Eight started to whittle down further when Arthur Young combined with
Ernst & Whinney while Deloitte Haskins & Sells merged with Touche Ross to form Deloitte & Touche,
usually referred to as Deloitte.
The Big Six became the Big Five in 1998 when Price Waterhouse merged with Coopers & Lybrand
to form PricewaterhouseCoopers, now known as PwC.
And when Arthur Andersen collapsed, the Big Five became the Big Four.
Their dominance of the industry has grown ever since.
In 2019, the Big Four had more than 75% of the global accounting market share, nearly
a 10 percentage point increase from the year before, while their revenues during that financial
year exceeded $154 billion.
The group also has a lock on the world’slargest public companies.
In 2019, just five of the 500 companies in the S&P stock market index were audited by
a non-Big Four firm.
In the U.K., all companies that make up the FTSE 100, the country’s blue-chip index,
were audited by one of the Big Four in 2018.
This collective dominance is one reason why regulators are attempting to prise the audit
market open to tougher scrutiny and fresh competition.
Critics of the Big Four also point out that despite all their resources, including over
a million employees, there have been several high-profile failures to uncover massive frauds.
A few months after Enron filed for bankruptcy, a bigger accounting scandal involving U.S.
telecommunications company WorldCom erupted, this time ensnaring KPMG, who took over the
accounting books from the embattled Arthur Anderson.
While the Big Four managed to emerge relatively unscathed, more accounting scandals continued
to rock investor confidence in the years ahead.
I wouldn’t hire you, to do an audit of the contents of my fridge.
These include the demise of Lehman Brothers in 2008, which was audited by Ernst & Young,
now known as EY,
Lehman has lost – you can see right there – 36% of its value.
The insolvent construction giant Carillion, which counted Deloitte and KPMG as its auditors,
We were a customer of Carillion, not the manager of Carillion.
Tour operator Thomas Cook, whose accounts were signed off by PwC and EY, and the 1MDB
scandal, which tainted three of the Big Four firms.
In 2020, German regulators examined EY for approving the accounts of online payments
company Wirecard, for more than ten years, before it filed for insolvency.
Critics believe they avoid properly scrutinizing their clients’ accounts because this could
threaten their consultancy work.
Along with auditing, the Big Four offer other services such as management consulting, taxation,
market research and legal advisory services.
In fact, these non-audit services provide the lion’s share of the Big Four’s income.
In the U.K., only a fifth of the Big Four’s total revenue is generated from auditing.
In the case of Enron, Arthur Andersen was earning more from the consulting services
it provided to the energy firm than it did from its auditing activities.
Critics also claim that the strong growth of the non-audit business, which resulted
from changes in the business environment for accounting firms in the 1970s, has impaired
the robustness and objectivity of audits.
While the standardized approach to audits ensures that financial statements are fairly
stated without material discrepancies, and that appropriate internal controls are in
place, this has led to a mismatch in the expectations and limitations of audits.
In fact, a study of nearly 2,700 cases of workplace fraud in 125 countries found that
a majority are uncovered through tip-offs — showing the importance of whistleblowing
hotlines — as opposed to internal or external audits.
The Big Four insist, however, that regulations restricting consultancy work are sufficient
to protect the independence of their auditing services.
These include the Sarbanes–Oxley Act of 2002 in the U.S., and Japan’s Financial
Instruments and Exchange Act.
In the U.K. and EU, auditors are not allowed to provide consulting advice to businesses
one year leading up to and during the term of an audit contract.
Companies included in the FTSE 350 Index, the 350 Biggest companies in the U.K., must
also put their audit out for tender every 10 years and must change auditors every 20 years.
However, these restrictions, according to regulators, aren’t fool proof.
When an auditing contract ends, the firm can immediately begin doing consultancy work for
the same company, making it less likely for existing auditors to challenge a client if
it jeopardizes future contracts for lucrative non-audit work.
Some politicians also argue that these regulations are overly complex and hinder competitiveness.
Even with more regulatory paperwork and longer annual reports, these accounting scandals
have not abated.
There are signs, though, that the Big Four realize that the status quo cannot continue forever.
Deloitte has set up an audit governance board, which it claims will “focus on the policies
and procedures for improving audit quality.”
And EY, in the wake of the Wirecard scandal, has told its clients that auditors should
play a bigger role in detecting fraud.
The U.K.’s accounting regulator, the Financial Reporting Council, has also set a 2024 deadline
for the Big Four to separate their audit units from their other services, although the watchdog
stopped short of demanding a full, structural break-up of the firms.
The Big Four, in response to queries from CNBC, said that they have taken steps to enhance
audit governance, including engaging with the Financial Reporting Council on the principles
of operational separation.
Audits serve a crucial role in instilling public confidence in financial markets.
Yet, the same costly errors that resulted in the demise of Arthur Andersen nearly twenty
years ago are still happening today.
Unless the industry can restore confidence that their audits are independent, objective
and uncompromised, the pressure will build on regulators to act before the financial
world is engulfed in yet another accounting scandal.
Hi guys, thanks for watching our video. I briefly mentioned Wirecard in this story.
We made another explainer on that scandal specifically so do check that out
and we'll see you next time.